Systemic losses in banking networks: indirect interaction of nodes via asset prices

TL;DR

This paper introduces a solvable model of banking networks where initial shocks cause cascades of defaults through asset price interactions, highlighting systemic risk without direct interbank links.

Contribution

The paper presents a novel analytical model of banking networks with multiple default waves driven by asset price interactions, without direct interbank connections.

Findings

Model captures multiple default waves and systemic risk.

Default cascades are driven by asset price reductions.

Probability distribution of total losses extends Vasicek distribution.

Abstract

A simple banking network model is proposed which features multiple waves of bank defaults and is analytically solvable in the limiting case of an infinitely large homogeneous network. The model is a collection of nodes representing individual banks; associated with each node is a balance sheet consisting of assets and liabilities. Initial node failures are triggered by external correlated shocks applied to the asset sides of the balance sheets. These defaults lead to further reductions in asset values of all nodes which in turn produce additional failures, and so on. This mechanism induces indirect interactions between the nodes and leads to a cascade of defaults. There are no interbank links, and therefore no direct interactions, between the nodes. The resulting probability distribution for the total (direct plus systemic) network loss can be viewed as a modification of the well-known Vasicek distribution.